One of the challenges investors face is calculating inflation into your retirement portfolio. The amount of money that you support your lifestyle today is probably vastly less than what you will actually need once you retire. As has been the case for a human lifetime, inflation is likely to be a constant presence well into the future, despite the occasional media and economist discussions about deflation.
How can you prepare your retirement portfolio for inflation without knowing exactly what it will be in the future?
Estimating Future Inflation
Estimating price levels in the future is impossible to do with any precision. There are a lot of variables, including times of relative price stability and others of rapidly rising prices. In order to invest effectively, it’s absolutely necessary to make some sort of reasonable estimate as to what price levels will be by the time you retire.
Let’s say that you’re 35 years old, and you plan to retire at age 65. That means you will have to project where price levels will be in 30 years. Obviously, there’s no tool that can provide an accurate picture of the future. But we can look back, and see what inflation has done to the value of a dollar over the past 30 years, and use it as a loose guide.
You can do this using the Bureau of Labor Statistics’ Inflation Calculator. It’s a simple tool, in which you enter just three numbers – the dollar amount, the starting point year, and the current year.
By entering “1986” – to cover the past 30 years – and then $1,000, we find that in 2016, it will take you $2,191.93 to buy the same amount of products and services that $1,000 bought 30 years ago. Let’s round that up to an even $2,200, and say that whatever amount of money you will need to save for retirement in today’s dollars will need to be multiplied by 2.2 in order to cover estimated future inflation.
In that scenario, if you believe that you will need $1 million in today’s dollars to support your retirement, your savings target can be $2.2 million to account for the effects of inflation between now and then.
Investing for Inflation After Retirement
One of the complications involved in accounting for inflation in connection with retirement is that inflation will not stop once you retire. And with people typically living into their 80s and 90s, your investment money will have to cover your living expenses for another 20 or 30 years after you retire. Inflation will continue to be a factor.
You will have to assume inflation will continue throughout your lifetime. That means you will have to be fully prepared to reinvest at least part of your investment earnings back into your portfolio to account for still higher price levels in the future.
This gets down to the question of how much money you should be withdrawing from your retirement portfolio after you retire?
The safe withdrawal rate offers some guidance here. The theory holds that if you withdraw no more than 4% of the balance of a well diversified retirement portfolio, you’ll never run out of money.
The safe withdrawal rate means that your average annual return on investment will need to be greater than 4% per year once you retire. So if you determine that a 3% annual inflation factor is a reasonable estimate, then you will need to earn 7% on your portfolio each year.
In doing so, you will be able to safely withdraw 4% each year for living expenses, while the remaining 3% is reinvested to keep your portfolio adjusted for inflation.
It’s important to realize that your investments won’t hit 7% each and every year. But that does need to be your average. There may be one year in which you earn 10%, another year only 3%, and still another in which you lose 4%. That’s okay, as long as your average return hits the target over a long time frame.
Best Investments to Cover The Impact of Inflation on Your Portfolio
Interest-bearing investments, like certificates of deposit, used to be the mainstay of retired investors. They provided a steady income flow, as well as protection of principal value. But with today’s microscopic interest rates, fixed income investments alone will not provide for retirement. You cannot live on a 1-2% return on your money, and have both enough income to live on, as well as to cover for inflation.
Historically, stocks and real estate have been the best investments to counter inflation, particularly the persistent, low level variety we’ve had in recent decades.
Stocks have returned an average annual rate of return of something in excess of 10% since 1928.
The situation is similar with real estate. However, as many retirees don’t want to be involved with owning and managing rental properties, you may want to take a close look at real estate investment trusts, or REITs. They invest in real estate either through direct equity participation or by providing mortgages. They have earned an average annual return of 10.6%, which puts them right in the range with stocks.
But since stocks and real estate carry higher risk than bonds and other interest-bearing investments, you shouldn’t have 100% of your money invested in them. Instead you want to achieve a blend that will provide you with the needed rate of return, but also provide a measure of safety.
Let’s take a look at a sample retirement portfolio that could historically keep pace with inflation:
Say you decide you need a 7% annual average rate of return on your portfolio once you retire. By investing 67% of your portfolio in stocks and real estate, and 33% in interest-bearing investments you can reach 7%. That will give you a return of 6.7% on stocks and real estate (67% X 10%) and 0.33% on interest-bearing investments (33% X 1%), for a total average return of just over 7%. (keep in mind this is an example, and not a guaranteed return).
Depending on your current investment portfolio and future retirement needs, you may need even higher returns to reach your retirement goals. That means that you would need to put a larger percentage of your portfolio into stocks and real estate.
A Retirement Happy Ending?
None of these strategies can guarantee 100% inflation protection. But diversifying your investment portfolio to protect against inflation is a prudent move and will leave you better prepared than if you took no action all.
It is probably you will experience times of high inflation during between now and your retirement. This is even more likely if you have more than one or two decades between now and your retirement. Your goal is to continue to invest through these periods. Diligent investing over time will help your investment portfolio keep pace with inflation. But the flip side is that the rate of inflation in the future may be less than you anticipate, which will leave you in an even better position when retirement comes around.